More On The Fed

["ÁÎ×Ó¹â Henry C.K.Liu ¹ù¤l¥ú" <hliu@xxxxxxxxxxxxxx>]

Financial markets are not the real economy.  They are shadows of the real
economy.  The shape and fidelity of the shadows are affected by the
position and intensity of the light source which are market sentiments.

In previous posts, I have tried to showed that populist reaction to "money
trusts" led to the creation of the Federal Reserve System in 1913.   But
the institutional character of the Fed over the decades has since
developed more allegiance to the soundness of the financial market system
than to the health of the real economy, let alone the welfare of the all
the people.  Granted, conservative economists argue that a sound financial
market system ultimately serves the interest of all.  But the economy is
not homogenous throughout.  In reality, sectors of the economy and
segments of the population, through no fault of their own, may not survive
the down cycles to enjoy the long term benefits.

I have already covered how Arthur Burns, in trying to insure Nixon's
re-election, laid the seed of hyper inflation.  In hoping to get
reappointed by Carter, Burns continued to pursued an easy money monetary
policy in the first year of the Carter administration.  To Burns'
disappointment, G. William Miller became Chairman of the Fed in 1978.

Miller, CEO of Textron, true to the empire building tendency of a CEO,
decided to halt the membership decline in the system.  Commercial banks
had been electing to withdraw from the Federal Reserve System in protest
of the Fed not paying interest on reserve balances.  Banks which withdrew
could place their lower reserves required by state banking regulation, in
corresponding banks to earn income from securities. During the 70's, as
hyper inflation pushed up interest rates, the no-interest hidden "tax" on
Fed banks became proportionately more burdensome.  Miller decided to pay
interest to member banks for their reserves, over Congressional opposition
which considered it another give away to the big banks.  Not only are the
big banks getting free safety net protection through emergency borrowing
at the Fed's discount window, they also enjoyed free check clearing and
payment system from the Fed.  Congress thought the banks were pigs for
complaining about the no-interest "tax" since the tax was lower than user
fees for services the banks received. As it was in the 1980s, the
effective tax rate for financial institutions was only 5.8%, compared to
34.1% for retail, 24.5% for electronics, 16.4% for aerospace, 10.9% for
utilities.

Senator Proxmire and Representative Reuss answered Fed interest payment
with the Monetary Control Act of 1980, enacted just when the Fed pushed
interest rates to historical peaks, requiring all depository institutions,
members and non members alike to maintain reserves with the Fed.
Ostentatiously, since the Fed now pays interest on deposited reserves, the
small banks ought to at least get the benefits of Fed services and
protection and bypass the fee paying correspondence relations with big
banks.

It was amazing that the Fed was able to get Congress to consolidate the
Fed's institutional base at a time when the Fed was imposing intrusive
conditions in the private economy.  The rationale was only marginally
based on economics and heavily on politics.  Fed membership was a
non-issue as far as monetary control was concerned and Governor Henry
Wallich, the Fed's most scholarly economist, said as much openly.  The
legislation favored the Fed's main constituent, the large money center
banks, forcing all other regional and local financial institutions to fall
in line and accept the terms that are most operative for the big banks.

The Fed's legislative victory was delivered on the back of a larger issue
whose time seemed to have arrive in America - the deregulation of finance.
  In companion legislation, Congress repealed virtually all of the
remaining government limits on interest rates and regulation on lending
that had existed since the New Deal, much as HR10 did in repealing Glass
Steagall last year.  The price of money was free at last to seek its
"natural" equilibrium in the market place.  The prime rate was above 15%
in the beginning of 1980 when the deregulation legislation reached its
final stage.  The Democratic Congress voted overwhelmingly for a package
that condemned borrowers to high cost and favored lenders with high
returns.  The populist regulation Q, which regulated for several decades
limits and ceilings on bank and S&L interest, was phased out.  Banks were
allowed to pay interest on checking account - the NOW accounts, to lure
depositors back from the money markets.  S&Ls traditional interest rate
advantaged was removed, to provide a "level playing field", forcing them
to take the same risk as commercial banks to survive.  Congress also
lifted restriction on S&Ls commercial lending, instead of the traditional
home mortgages, which promptly got the whole industry into trouble that
would soon required an unprecedented bailout.  State usury laws were
unilaterally suspended by acts of Congress in a flagrant intrusion on
state rights.

The political coalition of converging powerful interests was evident.
Virulent high inflation had damaged the holders of financial wealth,
including small savers created by a period of benign low inflation
earlier, that even liberals felt something has to be done to protect the
middle class.  There was even a devious argument that universal Fed
membership serves to dilute the institutional bias of the Fed toward big
banks.  Commercial banks of course argue for free market competition when
they knew every well that predatory acquisition rather than fair
competition was what unregulated markets sustain.  Labor, small business
and small local banks and S&Ls complained, to no avail.  Many Fed
economists, Volcker included, actually knew that financial deregulation
with the elimination of interest rate ceilings would weaken the Fed's
control over expansion of credit.  The reserve requirement was reduced
from 16.5% to 12%.

Volcker having served four years as president of the NY Fed, replaced
Miller as Fed Chairman on July 23, 1979.  Miller, after only seventeen
month at the Fed, had been named Secretary of Treasury as part of Carter's
desperate wholesale cabinet shakeup in response to popular discontent and
his declining authority.  After isolating himself for ten days at Camp
David, Carter emerged to make his speech of "crisis of the soul and
confidence."  The market dropped like a rock.  Miller was a fall back
choice for the Treasury, after numerous other candidates declined
telephone offers by Carter.  Carter felt that he needed someone like
Volcker to sustain needed bipartisan support in his time of crisis.  Bert
Lance was reported to have told Carter that by appointing Volcker, Carter
was mortgaging his own re-election to the Fed.

Volcker won the battle against inflation by letting blood run all over the
country.  The deregulation that made some sense under conditions of hyper
inflation were kept permanent under conditions of restored low inflation.
Deregulation put a stop to mom and pop operations in the financial sector,
by killing off all the moms and pops, quite the opposite of what Keynes
predicted that the abundant supply of capital would lower interest rates
to bring about the "euthanasia of the rentier."  High interest rates moved
wealth from borrowers to lenders and from bottom to top in the wealth
pyramid.   Moreover, the impact of high  interest rate modifies economic
behavior differently in different groups and even on different activities
within the same individual.  When the prime rate for some banks reached
over 20% in 1980, credit continued to expand explosively. High rates only
work to slow credit expansion if the rates were ahead of inflation.  Yet
even the Fed was not prepared to raise interest rates too abruptly.   The
market obviously did not moderate the pace of new lending by raising the
price of money, as long as inflation/interest gap remain profitable.  Yet,
deregulation diluted the Fed control of the supply of credit, leaving
price as the only lever.  Price is not always an effective lever against
runaway demand, as Greenspan is also finding out.  Raising the price of
money to fight inflation is by definition self neutralizing.

In the early weeks of 1980, the CPI was 17%, prime rate was 16% and
rising, and gold hit as high as $875 an ounce.  Having told the House
Banking Committee on February 19 that credit controls do not deal with the
"basic causes of inflation", the Fed announced on March 14 a program of
emergency credit controls not only on commercial banks, but also on
money-market mutual funds and retail companies that issue credit cards.
Banks would be limited to 9% credit growth instead of the 17% in February.
Only a week early, the FOMC, trailing inflation data, was forced to raised
the Fed Funds target to 18%.

The economy crashed abruptly.  GDP shrank 30% within three months.
Consumer credit, instead of growing by $2 billion a month, shrank by $2
billion a month.  Money dried up suddenly, leaving many projects hanging
in mid steam.  Construction loans could not roll over into permanent
mortgages.   Asset prices fell below their collateralized value (below
water).  Insolvency was widespread, with financial dead bodies strewn on
the sidewalks of every city.  For the first time in history a Democrat in
the White House pushed the country into recession, and in an election
year.

Senate majority leader Byrd of West Virginia expressed concern but was
rebuked by Proxmire, Banking Committee Chairman's technical lecture on
inflation and interest rates, a TINA argument. More unemployment and
bankruptcies were the needed medicine.

Then the Hunt brothers silver bubble burst, punctuated by sliver price
dropping from $50 an ounce to $10.  The banks had lent the Hunts $800
million to speculatively corner a sliver cartel, 10% of all bank lending
in  the past two months, at rising interest rates that inched toward 20%.
By March 31, the Hunts defaulted on their future contracts.  To prevent
systemic panic, Volcker engineered a private bailout from the 11 banks
with a new $1.1 billion, similar to the LTCM bailout.  The Fed waived
credit control rules imposed  only two weeks earlier.  Moral Hazard became
a common word.  The Fed had in the past refused request for bailouts from
Chrysler, NY City, Midwestern grain farmers, Lockheed, etc, in the real
economy, but it seldom refuses to bail out the financial markets.  TINA
was after all a selective doctrine.

More later

Henry C.K. Liu